What is Interest Rate Risk?

INTEREST RATE RISK : The earnings of companies and the performance of their shares
are sensitive to interest rate changes. Therefore, potential variability of investment returns
due to interest rate fluctuations is known as interest rate risk. The prices of debt securities
and all other securities with fixed payment are dependent upon the level of market interest
rates. When the interest rates rise, bond values will generally fall. The returns on other
type of securities also depend upon interest rates. The degree of sensitivity to interest rate
changes will naturally differ from company to company.
Recently companies have started issuing ‘floating rate bonds’. The rates of interest on
these bonds are linked to some floating rate such as ‘prime rate’ or the bank’s minimum
lending rate. When market interest rate rise, the bond rate rises and when it falls, the bond
rate also fall. This is a good way to circumventing the interest rate risk when interest rates
are on the rise. But in a situation where inflation is under control and interest rates are on
the decline, it is bound to be disadvantageous to the investors.
Interest rate risk is a major source of risk to the holders of high quality bonds i.e. the
changes in the interest rates. Interest risk arises due to the inverse relationship between
interest rates and prices of debt instruments. If interest rates rise, prices of existing debt
securities fall to realign with the new market yield. The high quality bonds are not subject
to either substantial business risk or financial risk. Therefore, they are called high quality
bonds. Their prices are determined by the prevailing level of interest rate in the market.

Interest rate risk affects all investors in high quality bonds regardless of whether the
investors hold short term or long term bonds. Changes in the interest rates have the
greatest impact on the market price of long term bonds. The changes in interest rates may
not have much impact on the market price of short term bonds, but the interest income on
short term bond’s portfolio may fluctuate from period to period, as interest rates change.